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Beware the Rule of 78s when signing up for an auto loan

Beware the weight of a pre-computed auto loan where the Rule of 78s has been used to figure interest. (Photo: ThinkStock)

When you’re looking into an auto loan, watch out for ones that use an old formula called the “Rule of 78s.” This is a method of calculating a rebate of finance charges when a customer repays their debt early. In actuality, the rebate ends up being a “sneaky prepayment penalty,” claims Bankrate.com. The loan-padding scheme, which was devised in the days before calculators, is also known as the sum of the digits method (adding the digits 1-12 together, with those digits corresponding to the months of the year.

Rule of 78s slams borrowers with extra interest charges

Early in the life of an auto loan computed using the Rule of 78s, extra finance charges are inserted. The lender ends up getting three-quarters of a loan’s interest in the first half of a loan term, which makes it more than front-loaded. This technique is applied to a pre-computed loan rather than a simple interest loan.

By way of explanation, a pre-computed loan deals with interest in the following manner. Total interest owed over the life of an auto loan is determined via a standard amortization table. If a consumer signs on for such an auto loan, they agree to pay the principal and full interest over the entire term of the loan. It’s all calculated in advance and you’ll have to pay every penny. With a simple interest loan, the consumer has to pay based on the daily balance. The quicker the auto loan is paid, the less interest is required. If there’s no prepayment penalty on a simple interest loan, prepayment is definitely the way to go.

How does the Rule of 78s hurt the borrower?

A perfect example would be a 48-month pre-computed auto loan. Even if you pay it off in 36 months, you would still have to pay for 48 months of interest. That is, until the lender comes back and says that you won’t have to pay it because he will figure a payout amount including a “rebate” for the extra 12 months of finance charges you supposedly won’t have to pay. But here’s where the Rule of 78s hits you: the lender applies more of your previous payments toward interest and less toward the principal balance. Applying less to the principal raises the total amount owed. And the higher the interest rate is on a pre-computed loan using the Rule of 78s, the higher the payoff amount is going to be.

Congress outlawed Rule of 78s loans in 1992

But the ban only applies to loans longer than 61 months, says Bankrate. How convenient is that for lenders – and inconvenient for consumers! For loans of five years or less, the jury is still out on a federal level as to whether the practice will be put down. Currently, 17 states prohibit pre-computed Rule of 78s-style loans, whether it be a car loan or otherwise. Thankfully, simple interest loans are much more common in today’s auto finance market. Nevertheless, consumers should watch out for it, particularly if they have less-than-perfect credit that dictates that they must borrow at a slightly higher rate. Interest refunds and rebates are a path to financial trouble.